The impact of Enron’s tailspin on the energy industry has been more severe than expected, Merrill Lynch analyst Carl Kirst said in a research note reviewing the investor exodus from merchant energy stocks this week — prior to Wednesday’s small rebounds.

“We expected it to be a black eye on the industry,” said Kirst. “However, the crisis of confidence has been particularly severe.”

When Enron filed for bankruptcy protection, Kirst expected there would be credit and liquidity risks among its peers as well as greater accounting scrutiny and possibly increased regulation. But the fallout appears to be deeper and more far-reaching than originally was anticipated.

“The capital markets have effectively been shut down for many of our energy merchants and unregulated power companies as equity and debt values have plummeted,” he said. “We believe investor concerns are primarily threefold: 1) profit growth/accounting/earnings quality, 2) balance sheet and liquidity concerns and 3) near-term earnings outlook given a multitude of challenges at hand.

“One of the broadest concerns has probably been the profit growth/accounting of the sector,” he added. “FAS 133 mark-to-market accounting, while intended to enhance disclosure, has in many places done more harm than good. While problems do exist, mark-to-market itself is necessary — and vital — to managing risk. To combat earnings complexity and uncertainties, we expect companies to provide more disclosure on their MTM gains/losses, duration of their book (and hence timing of cash flow recognition) and ultimately the greater use of cash flow valuation for merchant activities in conjunction with the more traditional P/E.”

But chief among the near term concerns is leverage and liquidity. With little to no access to the capital markets, “the issue of perception versus fundamentals is moot,” he said, and “over the foreseeable future, balance sheet strength and cash generation will be key. As we learned with Enron, a trading business is only as good as its credit and credibility.”

If that’s not bad enough, the heating season has been mild, prices are low and the economy is struggling to recover. There is much “uncertainty regarding the long-term marketing business,” Kirst admitted.

However, he expects all this could blow over because of the vital roles that these companies play in the economy. “Longer term, we continue to see risk management as not only a viable but necessary business as we believe large gas and power end-users, producers, utilities and munis transitioning through deregulation will continue to need their long term energy exposure and risk managed.

“The most likely scenario is a greater return of activity once the capital markets settle down. While sector risk has clearly been on the rise, we believe at current historically low P/E multiples valuation for the [energy merchant companies] is compelling. At the current depressed prices, we believe most valuations more than reflect any potential earnings risks. Downside risk would likely be liquidity crisis driven.” Kirst is maintaining Strong Buys on Dynegy and Williams and a Buy on El Paso.

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